Kindle-ing Thoughts on Tech Pricing

Recently, I bought the newest version Kindle from Amazon, $189 with 3G connectivity (WiFi only is $139), plus, since I am a klutz who drops everything electronic, $35 for a protective cover. My reaction to the prices was that $189 is incredibly low considering the awesome functionalities embodied in the device, and that $35 is exorbitant for a bit of cardboard wrapped in thin leather. I could have jury-rigged a cover, of course, but the Amazon version locks onto the device and the order button was right there tempting me like the fatal glass of beer, so I bought it.

I loaded a bunch of books, but the device has been quite squirrely, requiring constant re-boots, freezing, and in general exhibiting that free will so characteristic of computers. (AI is already here, and it is mean, and don’t let anyone tell you different.)

I pinged Amazon a week ago, and received an immediate response that I should talk to a live human. So yesterday I got around to pinging again. I was instructed to call a particular number, which I did, and was immediately called back – no hold time with awful music and no endless-loop voicemail menus – by Max, who was not at all surprised by my story, and quickly and courteously walked me through the fix, which was to remove the cover and throw it out.

It seems that the metal prongs that lock my model cover to the Kindle somehow cause static that interferes with the operation. Max was multiply apologetic, until finally I cut him off, saying that stuff happens and the important thing is how a company responds, and on this score Amazon was doing fine so no big deal. On the evaluation sheet which soon appeared in my email, I gave both him and the company top scores.

The interesting thing was the discussion of the cover. Max informed me that Amazon would of course refund me the $35 purchase price, and that it would also give me a $25 credit which I could use to buy an even better cover, this one with a reading light built in and gold-plated prongs that do not cause static, and which as it happens sells for $60, so it would be free to me. He smoothly elided the possibility that I could take my refund and my credit and use it for some other purpose, doing without the Amazon cover, a choice obviously unworthy of a superior consumer such as myself.

I soon had an email which contained a link to consummate the new deal, which I punched. I had been tempted by the lighted version originally and had held my decadence in check, but given the found-money extra $25, I succumbed, as any good decision theorist would predict.

Afterward, pondering why Amazon was so eager to get me to take this cover upgrade, I realized that this interchange has several lessons for understanding the tech world.

The call-back after I pinged them was instantaneous, which means, since I called mid-morning on a weekday, that Amazon chooses to have enough helpers on hand so that someone is quickly available. It handles the lumpiness in the queue by creating excess helpage capacity rather than by letting customer wait times go up and down. Since I do indeed regard my time as valuable, I appreciate this courtesy. (Comcast has a reasonable alternative – rather than have the caller wait, you leave a number and they call you back, pretty close to the time predicted.)

Amazon also wants me to log off with the sense that I got good value for money, and that I can rely on the company to help me do this. Thus it discounts its books and shows the savings, it provides easy to links to used books, even when these directly undercut its own prices, it tried to make Kindle books a real bargain until the publishers stepped in and stopped this nonsense, and its speed of shipping and delivery is awesome. The prime program, whereby for $72/year you get free two-day delivery, may be the greatest lock-in device ever invented, because, again as a decision theorist would tell you, in my mind Amazon ships for free because I immediately forget about the sunk cost annual payment.

The cover is not a bargain. However, the purchase was purely voluntary on my part, since I made the decision to buy immediately rather than mess around with finding an alternative; in other words, I made the time/price trade-off, and decided it was in my favor, and a cover that locks onto the Kindle is indeed superior to any alternative, so I am not unhappy with overall the value proposition.

The second lesson concerns pricing, and again the analysis revolves around the cover. Amazon, like most of the tech world, is a business with heavy investment costs and low marginal costs. The value of the physical materials in a Kindle is trivial, but the development cost was in probably in the hundreds of millions. In this context, the “price should equal marginal cost” pricing so beloved of academic economists is inapplicable nonsense. (For elaboration, see here and here.) In addition, the development costs of the cover were trivial (perhaps not quite enough on the engineering end), but the materials are certainly not worth anywhere near $35 or $60, so the profit margin is fat.

In any high investment/low marginal costs situation, the seller wants to discriminate on price, differentiating among buyers according to the value they place on the service. This is, by the way, good for all, even those who pay a higher price than others, because it allows the seller to spread the fixed investment costs over a broader base. If the price were too high for the buyers on the edge, and they stopped buying, then those for whom the service is most valuable would have to pay the entire investment cost.

So Amazon has found two ways to differentiate on price, or, rather, to let customers differentiate themselves. The first is the steep price gradient between the WiFi only and the 3G version, which allows someone who really wants a bargain Kindle to get one. I seriously doubt that the price differential reflects any real world difference in either development or production costs of the two versions.

The second and more ingenious price differentiation is in the cover. A cover for any portable electronic device really is a wise idea, so one can regard Amazon as selling a Kindle/cover package for $225 or a Kindle/cover/light package for $250. But that is not how the deal is set up. You are lured in with the basic price of $189, which may well be below the real total cost of the Kindle itself, and then decide “yeah, a cover is a good idea,” and then make the decision just to buy for $35 (or more) something that probably costs less than $5 to make. In fact, I bet most of Amazon’s profit on the total package comes from that cover sale, which is why Max was so anxious to upsell me.

Note that I am admiring, not protesting. Jeff Bezos, generations of savvy retailers salute you, including Alfred P. Sloan, whose GM perfected the concept of taking a Chevy chassis, attaching various levels of add-ons until it became a Cadillac, and increasing the profit margin at every step while making his customers proud to upscale. But, to repeat, this was also good for the Chevy purchasers, who benefitted from the high margins on Cadillacs, and for all other purchasers, who benefited from the economies of scale of large production. Without the price differentiation, everyone would have been worse off.

The important point is that the necessity for this kind of complicated pricing calculation whereby the firm gets the customers to self-differentiate and stay happy, is crucial to a broad swath of tech businesses, including carriers and mobile phone providers. There is simply no way to reconcile it with “net neutrality,” which is an amorphous concept that does not mesh with the importance and utility of price differentiation. I can’t wait to see the FCC is having hearings on how much a carrier must charge for the covers it supplies with its subsidized phones. Indeed, since Kindle content is transmitted via AT&T wireless, maybe the FCC will have to get involved directly.

I will make one prediction about any FCC intervention, though — Amazon manages to keep me a happy consumer, but I bet I will wind up a lot less happy after the government gets through helping me.

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